THE CORE CONUNDRUM - Guggenheim Partners

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SECTION 3 Future Investment Blueprint While it may seem that increased credit and duration risk have become prerequisites to generate yield, there is a more sustainable, long-term strategy that relies on the ability to uncover quality, investment-grade opportunities outside of the traditional benchmark-driven framework. Short-Duration Strategy Predicated on our view that the risk to interest rates is to the upside, we would advise investors to shorten portfolio duration and look for innovative ways to approach core fixed-income investing. Shortening duration offers a buffer against rising rates, but this generally comes at the expense of yield, particularly in corporate credit securities. The presumed positive correlation between yield and duration in the investment-grade universe has driven demand down the credit spectrum into lower-rated, high-yield bonds. A broader investment focus beyond the traditional core fixed-income framework demonstrates that lowering duration and producing attractive portfolio yields do not necessarily have to be mutually exclusive investment objectives. Within the investment-grade universe, floating-rate collateralized loan obligations (CLO) and shortduration asset-backed securities (ABS) offer similar yields to longer-dated corporate bonds with significantly less interest rate risk. While traditional securitizations of credit card receivables, student loans, and auto loans represent the majority of the ABS market, the sector has diversified into more specialized, niche segments of securities backed by various types of collateral, such as aircraft and shipping container leases, timeshare vacation ownership interests, and franchise fees. Largely owing to its association with the subprime crisis, these types of lesser-known, “orphan” credits suffer from a lingering negative connotation. The illiquidity and complexity of these non-traditional, “off-therun” sectors provide opportunities to generate yield in excess of comparably rated corporate credits. While corporate bond investors are exposed to the credit risk of a specific issuer or entity, idiosyncratic risks are mitigated in CLOs and ABS through large, diversified collateral pools. Additionally, these securities offer significant downside structural protection during stressed economic environments 10 | FUTURE INVESTMENT BLUEPRINT GUGGENHEIM PARTNERS
through overcollateralization, excess spread, reserve accounts, and triggers that cut off cash flows to subordinated tranches. Lastly, the amortizing structures of many asset-backed securities reduce credit exposure over time, while risks remain constant in corporate bonds due to their bullet maturities. Monetizing Complexity Despite the generally positive credit fundamentals in traditional ABS sectors, low nominal yields decrease the attractiveness of these segments. These traditional sectors, which represent the lion’s share of the ABS exposure in the Barclays Agg, have a weighted-average yield of 1.0 percent. Yields on credit card ABS are currently below 1 percent, while yields on auto loans are between 1 and 2 percent. Although student loans offer slightly higher yields of 2 to 4 percent, the regulatory risk coupled with our belief that loan prepayments will be low, which would extend the average life of the securities to 10 to 15 years, significantly reduce their relative attractiveness. Relative Value of ABS and CLOs vs. Corporate Bonds Spread Comparison between BBB-AA-rated ABS, A-rated CLOs, and BBB-A-rated Corporates 2,100bps 1,800bps 1,500bps 1,200bps 900bps 600bps 300bps 0bps 2002 2004 2006 2008 2010 CLO ABS Corporate 2012 Largely owing to their association with the subprime crisis, CLOs and ABS frequently offer excess yield over corporate bonds given their increased complexity and illiquidity. Source: JP Morgan, Bank of America Merrill Lynch. Data as of 12/31/2012. Spread High: Low: Avg: Last: CLO 2,070 68 460 315 ABS 1,983 104 431 200 Corporate 710 87 199 163 11 | FUTURE INVESTMENT BLUEPRINT GUGGENHEIM PARTNERS
Page 1 and 2: PORTFOLIO STRATEGY RESEARCH | FEBRU
Page 3 and 4: SECTION 1 The Core Conundrum In an
Page 5 and 6: Assessing the Relative Value of the
Page 7 and 8: SECTION 2 Coping with New Market Re
Page 9: Nominal Total Return Era of “Retu
Page 13 and 14: Barbell means to structure a portfo
Page 15 and 16: The Changing of the Guard The Futur

THE CORE CONUNDRUM - Guggenheim Partners

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